How to Trade the MACD Divergence Part 2

When to Trade MACD Divergence + Stop Loss and Take Profit Levels

Last time we talked about how to spot a MACD divergence and we looked at the different types of divergence, regular and hidden. See Part 1 HERE. Today we'll go over regular divergence in more depth, explaining where to put the stop loss and take profit orders and toward the end we'll go over the conditions under which this type of divergence performs best.

Since the regular divergence is a trading setup that aims to pick tops and bottoms to some extent, setting the stop loss is fairly straightforward. See the chart below for an example of a MACD divergence spotted on Friday, August 17 2012.

The stop loss in this case would go just above the swing high, which was at 1.2381. The entry was a conservative one, meaning we waited for the MACD histogram to close down to confirm the sell signal. Entry at the hourly close was at 1.2359. Setting the take profit can be little tricky, you could use a previous support or resistance level, a moving average or a just use the same distance as the stop loss level as take profit, in our case 23 pips. This is called 1R, meaning your take profit is the same as 1 Risk (risk=stop loss). On the chart above we can see that price not only reached our Take Profit = 1R level but continued to fall, in fact the EUR/USD pair lost 71 pips in few hours, marking a swing low of 1.2288 before recovering.

Setting take profit at 1R is simple but it may not be the best course of option since it does look a bit arbitrary, so it's important to experiment with different ways to take profit.

Regular MACD divergence excels in a ranging environment

Now let's look in what conditions does regular MACD divergence work best. Last few days we got a perfect string of divergence signals. See chart below.

The EUR/USD pair was ranging in a 140-150 pips range and delivered 4 nice looking divergences. If we used 1R as our take profit level, we would have gotten 3 Wins and 1 Loss. The first signal was a loss mainly because the conservative entry got us in too late in this case, so even though price rallied 70 pips from our entry it wasn't enough to reach out TP, as our stop loss was set at 74 pips in this case. This example shows the arbitrary nature of using 1R as take profit level so it's good to remember to experiment with this. But even with a simple TP of 1R regular MACD divergence excelled in a ranging environment.

Now lets look at some trending periods. Being mainly a counter-trend or top/bottom picking trading signal, the regular MACD divergence performs poorly in a trending environment. See the chart below for an example of this.

During trends price can deliver several regular MACD divergence losses in a row. Price can make a new divergence as it makes a new bottom, but after we enter it stops us out with another new bottom and a new divergence. In the chart above, if we use 1R as our take profit level, we get 2 Wins and 3 Losses in this type of market.

In conclusion, the regular MACD divergence works best in a ranging environment, so try and identify ranges and stay out of the way of trends to put the odds in your favor. Good luck in your trading.